Read Scott Sumner’s lengthy defense of Eugene Fama and the Efficient Markets Hypothesis makes me want to refine what I said already about Fama’s recent New Yorker interview. This goes back, I suppose, to Larry Summers’ old point about ketchup economics, but I think people are talking past each other over the term “efficient.”
Let me quote Summers:
The differences I am discussing may be clarified by considering a field of economics which could but does not exist: ketchup economics. There are two groups of researchers concerned with ketchup economics. Some general economists study the market for ketchup as part of the broader economic system. The other group is comprised of ketchup economists located in Department of Ketchup where they receive much higher salaries than do general economists. Each group has a research program.
General economists are concerned with the fundamental determinants of prices and quantities in the ketchup market. They attempt to examine various factors affecting the supply and demand for ketchup such as the cost of tomatoes, wages, the prices of ketchup substitutes and consumers incomes. They examine a number of different types of data in an effort to explain fluctuations in ketchup prices. The models that are estimated have some successes in explaining price fluctuations but there remain puzzles.
Ketchup economists reject out of hand much of this research on the ketchup market. They believe that the data used is based on almost meaningless accounting information and are quick to point out that concepts such as costs of production vary across firms and are not accurately measurable in any event. They believe that ketchup transactions prices are the only hard data worth studying. Nonetheless ketchup economists have an impressive research program, focusing on the scope for excess opportunities in the ketchup market. They have shown that two quart bottles of ketchup invariably sell for twice as much as one quart bottles of ketchup except for deviations traceable to transactions costs, and that one cannot get a bargain on ketchup by buying and combining ingredi-ents once one takes account of transactions costs. Nor are there gains to be had from storing ketchup, or mixing together different quality ketchups and selling the resulting product. Indeed, most ketchup economists regard the efficiency of the ketchup market as the best established fact in empirical economics.
To say that the ketchup market is “efficient” from the point of view of a participant in the ketchup market seeking an opportunity trade at a profit is just a totally different thing from saying that the fluctuations of the ketchup market constitute an efficient element of a larger economic system. When people with a normal set of interests look at this
and wonders whether or not it’s “efficient,” he’s going to say that these sudden crashes have a lot of undesirable effects on people’s lives and that the speed and magnitude of the changes doesn’t seem grounded in any acts of God. It’s not as if an earthquake leveled the stock market or the productivity of the American workforce dramatically plummeted. It’s just not clear that predictability has anything to do with this. But if people just called the thesis that financial markets are unpredictable the “unpredictable markets hypothesis” then I doubt that people outside the Department of Ketchup would be very interested in arguing with them, and the likes of your humble blogger would certainly lack the quantitative chops to pursue the argument.